There has been many articles written in the last eight years about monetary policy being the only game in town. Depending on who is writing the piece, we should either drop to our knees and thank the monetary gods for our economic salvation or maybe be less awe struck and thank them for the role that they played as lender (or market maker) of last resort. The role that was originally bestowed upon them.
One could argue that in terms of their other responsibilities that Central banks have inherited over the last number of years, they have been less god like, and the report card has not been stellar. Growth has consistently been disappointing and inflation targets have not been met over a reasonable time frame. For the first seven years after the crisis, the disappointment has been met with more and more monetary stimulus in different forms. Still, the results were less than expected.
Many central bankers now say that the monetary accommodation needed additional fiscal policy stimulus to be able to achieve the targets in a more timely manner. I would point out that the economic projections that the central banks based their decisions on included government spending levels that existed at that point in time and their economic projections showed output gaps closing and inflation returning to target in response to the level of monetary stimulus that the central bank determined as appropriate. At the given level of fiscal stimulus, our central banks were telling us that the level of monetary accommodation they were providing was sufficient to get inflation back to target over a reasonable timeframe. It turned out to be wrong.
Now in hindsight, the academic in all central bankers will respond that this is understandable. The lowering of the neutral rate of interest in response to very valid reasons, like low productivity and an aging work force, does not give them sufficient room to lower rates by enough to generate the needed economic expansion.
But this was supposedly offset by alternative tools like quantitative easing which effectively lowered and twisted the yield curves to levels that could only be justified by overnight rates that were much lower than they were in reality.
The bottom line is that monetary policy, new tools and all, has been less effective than projected over the last seven years.
With this in mind, it was refreshing to see some out-of-the box thinking by David Dodge, an ex-Governor of the Bank of Canada. Bloomberg recently reported that he delivered a speech suggesting that there should be a co-ordinated increase in rates by the central banks of the developed world. I can imagine the gasps and guffaws from the hallowed halls and some questions on his mental well being. In their world, and with their models, it is predetermined that higher rates would cause lower inflation or even deflation. Moreover, the amount of fiscal expansion that you would need to offset the monetary stimulus would be politically unpalatable.
Even those that have not been taught in the finest universities know that if the central bank raised rates 100 or 200 basis points, borrowing rates would go up and the economy would slow.
Dodge argues that the world has changed significantly in the last ten years and the potential output of the economy is lower than the previous two decades. He asks policy makers to rethink policies to deal with the low growth disequilibrium that economies are currently facing. Since 2011 monetary policy has not been successful in restoring growth to its long term potential citing a lower natural rate of interest as the major challenge. However, instead of suggesting that even more monetary stimulus should be applied, this ex Governor suggests the opposite. Dodge argues that low interest rates may actually be doing harm to the economy, sighting the impact on savers and the lower incentive to spend and invest that “lower for longer” actually engenders. The thought process for many could be, “Yes rates are low, but I have been told they will be at these levels for a long time. I will wait to see how things unfold.” He also suggests that investment decisions may be delayed as business leaders are wary of a central bank with little ammo when the next downturn comes along.
He concludes that price and financial sector stability would be better served by somewhat higher policy rates combined with more expansionary fiscal policy and that employment or growth need not be sacrificed if calibrated appropriately.
Central bankers are trying to encourage risk taking in the economy. Maybe they will have to take some risks with outside the box thinking to get the economy to where it should be.
Don’t hold your breath.
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